How emerging market impact funds can reverse the curse of low (return) expectations

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Guest Author

Clemens Feil

Guest Author

Neil Gregory

Nowhere is impact investing needed more urgently than in emerging markets (EMs). Private investment is needed to lift billions out of poverty, create jobs, improve the environment, adapt to the effects of climate change and to fill gaps in provision of education, healthcare and financial services. Yet in these markets impact investing is farthest from its potential. 

To attract sufficient capital to meet these challenges, EM-focused private equity (PE) impact funds must deliver higher financial returns. This can only be achieved with greater investment discipline and a sharper focus on financial returns. 

Impact investing proponents have long sought to convince investors that pursuing positive impact does not entail accepting lower financial returns. And in developed markets (DMs), these promises are empirically supported. 

According to Q1 2022 data from Cambridge Associates, PE impact funds in DMs have provided similar returns to non-impact funds over time periods from three to 15 years. For example, 10-year returns on DM impact funds were 18%, on par with US PE funds, and three percentage points higher than non-US developed-market PE and VC funds. This success has continually attracted capital to DM impact funds, leading to larger and larger fund closings over the past two years. 

By contrast, the returns of PE impact funds in EMs are markedly worse than those in DMs. Over the same 10-year period, returns of EM impact funds were only 6% — that is 12 percentage points lower than returns of DM impact funds. 

Lower returns trigger a vicious circle

An EM ‘penalty’ is only partially responsible for the difference between EM and DM impact fund returns. Non-impact PE investment returns in EMs trailed those in DMs by five percentage points over 10 years. But impact funds in EMs also trail non-impact emerging market PE and VC funds by six percentage points. 

In other words, investors have given up some financial returns by investing in EMs versus DMs but have given up twice as much when investing in EM impact funds versus DM impact funds. The concern that pursuing impact means giving up financial returns thus remains salient in EMs — and lower returns scare away investors. 

Weaker equity returns imply that, on average, EM impact investors pay too much for assets. This can also crowd out other, non-impact, investors. It also makes it harder to attract investor talent, further exacerbating fund performance issues. 

The best way to attract capital and talent and to sustain investor demand is to provide a credible expectation of strong returns

When small is not so beautiful

Why, then, do EM impact funds perform significantly worse than both DM impact funds and non-impact EM funds? Part of it is an observation problem: Reliable information on fund performance is only available with a multi-year lag due to investment and realization cycles of five to ten years. 

Early impact funds in EMs were typically small, experimental, and with first-time fund managers — factors that generally lead to lower returns regardless of investment strategy or market focus. The more recent entry of larger funds helmed by experienced managers is too new to have demonstrated a track record.

The smaller scale of EM impact funds also affects returns. 

While DM impact managers have increased from raising $500 million funds a few years ago to $1-5 billion today, most EM impact funds remain at $500 million or less, making it harder to cover their operating costs (investment sourcing, diligence, and portfolio management), which are relatively higher in EMs. And lower returns keep these funds small, creating a negative loop. 

Larger pools of capital led by experienced managers are needed to break this cycle. In DMs, the industry has matured and larger mainstream asset managers, such as Bain Capital, TPG, and KKR, launched impact funds. We have not yet seen this in EMs.

Breaking the cycle

Both fund managers and fund investors can contribute to improving financial returns. Fund managers can:

  • Choose appropriate instruments and structures. With lower liquidity in EMs, exits can pose a challenge, and straight equity may not always be ideal. Structured equity, including preferred equity, convertibles, redeemable features and liquidity puts, can help the investors mitigate liquidity risks and optimize financing for companies.
  • Stay disciplined. Avoid overpaying for equity regardless of impact; this only lowers returns and deters non-impact investors. 
  • Avoid ‘layering’ risks. For example, investing in an early-stage company associated with an unproven entrepreneur, in a politically volatile country with a weak legal framework will likely not generate attractive risk-adjusted returns. Failed companies do not create sustained impact. 

Investors in funds can:

  • Seek diversification. Allocate capital to larger funds that are more diversified across industries and geographies. These have better prospects of achieving scale and reducing portfolio risk than single-country, single-sector or single-theme funds. 
  • Enforce discipline. Hold fund managers to the same returns standard as other PE funds. Since a trade-off between returns and impact is unnecessary, achieving impact is not an excuse for poor returns. Financial analysis and due diligence on funds should meet the same quality threshold; investors should not support funds with weak investment disciplines, however compelling the impact opportunity.
  • Target growth funds. Impact investors have often focused on start-ups and early-stage companies, but there is generally greater potential for impact through investing in companies with proven business models. These more mature companies have greater scale and lower operational, market, and technology risks. There is also a financing gap for check sizes larger than $15 million in most EMs (‘Series C gap’), showing many untapped opportunities.
  • Be patient. Seek out longer-life funds. Due to greater year-on-year volatility in EM returns, investing with a longer time horizon can improve average returns. This also helps with exits, as fund managers then have more time to wait for optimal exit opportunities and avoid accepting a lower exit price. 

The above steps can end the curse of low (return) expectations by closing the performance gap between DM and EM impact funds. It will create a virtuous circle, as higher returns will attract more capital to EM funds, help them achieve larger scale and further improve financial performance.


Clemens Feil is a growth equity investment principal at the International Finance Corporation. Neil Gregory is a lecturer at Johns Hopkins University.